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Fritz Schaefer, a foreign exchange trader at Bank of America in New York, is exploring covered interest arbitrage possibilities
Fritz Schaefer, a foreign exchange trader at Bank of America in New York, is exploring covered interest arbitrage possibilities. He wants to start with $1,000,000 or its yen equivalent in a covered interest arbitrage between the Japanese Yen and the U.S. dollars. He faces the exchange rate and interest rate quotes shown below. What is his final profit in U.S. dollar? Note: Interest rates are annual (360 days), while forward rate is for 180 days. Assumptions Arbitrage funds Spot rate (C/S) 180-day forward rate (€/$) US annual interest rate Japan annual interest rate Value Yen Equivalent $1,000,000 $104,400,000 V104.4/5 ¥102.2/5 2.40% 1.60% 360 fn.j FN-S S ? 104.4-1022 102.2 360 180 -.0421 = -4.21% n As(%) = i-i 1+i .024-016 =.0079 = -.78% 1.016 $17,699 $15,424 $23,347 O $25,785 None of the answers are correct
Expert Solution
OPTION A $17,699
1) Borrow $ 1,000,000 @ 2.4% for 6 months . Payment after 6 months = 1,000,000*1.012 = $1,012,000
2) Convert borrowed $ 1,000,000 Spot @ Y/$ = 104.4. It will be Japanese Yen= $ 1,000,000 *104.4= Y104,400,000
3) Invest Y104,400,000 @ 1.6% for 6 months. Amount receive after 6 months = Y104,400,000*1.008 = Y105,235,200
4) Convert Y105,235,200 180days forward @Y/$ = 102.2 . It will be Dollar = Y105,235,200/102.2 = $1,029,699
So we will receive $1,029,699 after 6 months and will return borrowed money amount of $1,012,000
Hence Arbitrage profit is $1,029,699-1012000= $17,699
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